Exchange Rates, the Balance of Payments and Competitiveness

An exchange rate is a price, and the thing being priced is a currency. Every single line in the balance of payments is simultaneously an order in that market. When a German buys a British car, she sells euros and buys pounds. When a British pension fund buys a US Treasury bond, it sells pounds and buys dollars. There is no entry anywhere in the balance of payments that is not also a trade in the foreign exchange market.

That single observation collapses two topics into one. The balance of payments is not "trade statistics" and the exchange rate is not "a number on a screen". The balance of payments is the ledger of foreign exchange transactions; the exchange rate is the price at which that ledger clears. Under a pure float, the price moves until the ledger balances exactly. Under a fixed rate, the price is held and the central bank supplies whatever quantity of currency is needed to absorb the difference — which is why fixed rates fail through reserves, not through arithmetic.

Two consequences follow immediately, and they are the two things most candidates get wrong.

First, a current account deficit is not money leaving the country. It is a net purchase of foreign goods financed by a net sale of domestic assets or a net increase in domestic liabilities. The money does not go anywhere; ownership does. A country running a current account deficit is, by identity, selling claims on its future output. Whether that is dangerous depends entirely on what the borrowing buys.

Second, a depreciation does not automatically improve the current account. A depreciation changes two things at once, and they pull in opposite directions. It lowers the foreign-currency price of exports, which raises export volumes. It also raises the domestic-currency price of imports, which raises import expenditure for any given volume. Whether the net effect is positive depends on whether volumes respond by more than prices worsen. That is a statement about elasticities, and it has a precise threshold. Deriving that threshold — not asserting it — is the analytical core of this chapter.

Everything else here is scaffolding around those two propositions.

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#1. Prerequisites

You must be able to do all of the following before starting. If any row fails, fix it first; the derivations later assume it silently.

One notational warning, because it causes more errors than any other single thing in this topic.

CONVENTION USED THROUGHOUT
e  = FOREIGN currency per unit of DOMESTIC currency.
     Example: e = $1.30 per £1.
A FALL in e is a DEPRECIATION of the domestic currency.
A RISE in e is an APPRECIATION.
Some textbooks use the reciprocal. Check before you read.
Always write the units. "The rate fell" is meaningless alone.

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#2. The balance of payments: the full accounting structure

#2.1 What the balance of payments is

The balance of payments is a record of all economic transactions between residents of one country and residents of the rest of the world over a period, usually a quarter or a year. "Resident" means economic residence, not nationality: a Japanese-owned factory in Wales is a UK resident.

It is a double-entry system. Every transaction generates two entries of equal size and opposite sign. That is not a convention chosen for tidiness; it is forced by the fact that every transaction has two sides. If a UK firm exports £10m of machinery and is paid in dollars, the UK has (i) exported goods worth £10m and (ii) acquired a foreign financial asset — a dollar deposit — worth £10m. Entry one is a current account credit. Entry two is a financial account debit (an acquisition of a foreign asset).

RULE: SIGNS
Credit (+) = a transaction that generates DEMAND for the domestic currency.
             Exports, income received, transfers received, capital inflows.
Debit  (−) = a transaction that generates SUPPLY of the domestic currency.
             Imports, income paid, transfers paid, capital outflows.
Every transaction produces one of each.
Therefore the accounts must sum to zero.

#2.2 The current account: four components, precisely

The current account records transactions in goods, services and income — that is, transactions that do not create or extinguish a claim on future output.

(1) Trade in goods (the visible balance). Physical merchandise crossing borders: cars, oil, pharmaceuticals, food. Recorded when ownership changes, not when the ship arrives.

(2) Trade in services (the invisible balance). Financial services, insurance, tourism, transport, education, business and professional services, royalties on intellectual property. A German tourist spending in London is a UK service export even though nothing crosses a border.

(3) Primary income. Income earned by a factor of production owned by a resident of one country but employed in another. Three sub-types: compensation of employees (a Polish worker in Ireland remitting wages), investment income (dividends on shares, interest on bonds, reinvested earnings of foreign subsidiaries), and rent. Note the crucial point: primary income is a return on the stock of foreign assets, and that stock is built up by past financial account flows. This is the channel through which today's current account balance changes tomorrow's current account balance.

(4) Secondary income (current transfers). Payments with no quid pro quo: workers' remittances, foreign aid, EU budget contributions, pensions paid abroad, insurance claims.

For many developing countries, secondary income is decisive. Remittances to low- and middle-income countries reached $685 billion in 2024, with India the largest single recipient at $129 billion, followed by Mexico ($68bn), China ($48bn), the Philippines ($40bn) and Pakistan ($33bn) (World Bank, Migration and Development Brief, 18 December 2024). Over the decade to 2024 remittances rose 57% while FDI fell 41% — so for a large group of countries, the most important source of foreign currency is a current account item, not a financial account one.

#2.3 Worked example: the UK current account

Source: ONS, United Kingdom Balance of Payments — The Pink Book, 2025 edition.

Three things to read off this table, all of which are worth marks.

First, the UK's goods deficit is enormous — 7.3% of GDP — and is very nearly offset by a services surplus of 6.4% of GDP. Any answer that says "the UK has a trade deficit because it does not make things any more" is only half the story, and the missing half is the half that is doing well.

Second, the improvement from a 3.6% deficit in 2023 to 2.2% in 2024 came mostly from primary income, which halved as a share of GDP as UK direct investment earnings abroad rose. Nothing about trade competitiveness changed materially. Current account movements are frequently driven by income, not trade, and candidates almost never say so.

Third, the more recent quarterly data confirms the pattern rather than the level: in Q4 2025 the UK current account deficit excluding precious metals was £8.4bn, or 1.1% of GDP, with a goods deficit of £55.5bn (7.2% of GDP) almost cancelled by a services surplus of £53.3bn (6.9% of GDP) (ONS, Balance of Payments, UK: October to December 2025, released 31 March 2026).

#2.4 The capital account and the financial account

Edexcel and much popular writing say "the capital and financial account" as though it were one thing. In the accounts it is two, and they are wildly different in size.

The capital account is small and technical. It covers capital transfers (debt forgiveness, inheritances crossing borders, migrants' transfers of assets) and transactions in non-produced, non-financial assets (the sale of a patent, a trademark, mineral rights, or land to a foreign embassy). For most countries it is a rounding error.

The financial account is where the money is. Four components:

• Direct investment (FDI) — acquiring a lasting interest, conventionally 10% or more of the voting equity, in a foreign enterprise. Building a factory abroad, or buying a controlling stake.
• Portfolio investment — equities and debt securities below the FDI threshold. Liquid, and therefore reversible.
• Other investment — bank loans and deposits, trade credit, currency holdings. This is where short-term "hot money" mostly sits.
• Reserve assets — the central bank's holdings of foreign currency, gold, IMF Special Drawing Rights. Changes here are the accounting footprint of intervention.

#2.5 Why the accounts must sum to zero — derived

This is stated in every textbook and derived in almost none. Here is the derivation.

Step 1: from double entry. By construction, every transaction generates equal and opposite entries. Sum every entry in the entire ledger. Each transaction contributes zero. Therefore the total is zero:

CA + KA + FA + Net errors and omissions = 0

where CA is the current account, KA the capital account, FA the financial account measured as net inflows, and net errors and omissions is the statistical residual for transactions that were mis-measured or unrecorded. This identity holds under every exchange rate regime. It is an accounting truth, not an economic result.

Step 2: the economic content, under a float. The accounting identity is empty until you ask what makes it hold. Consider the market for the domestic currency:

DEMAND for domestic currency
  = value of exports of goods
  + value of exports of services
  + income and transfers received
  + capital inflows (foreigners buying domestic assets)

SUPPLY of domestic currency
  = value of imports of goods
  + value of imports of services
  + income and transfers paid
  + capital outflows (residents buying foreign assets)

Under a clean float the central bank does not participate. The market must clear: demand equals supply at whatever price does the job. Setting demand equal to supply and rearranging gives exactly the identity above with the errors term set to zero. So:

Under a floating exchange rate, the current account and the capital-and-financial account must offset because the exchange rate is the variable that adjusts until they do.

The causation is not "the deficit causes the inflow" or "the inflow causes the deficit". It is simultaneous determination at a market-clearing price. A country with a deficit is a country whose residents want to buy more foreign goods, income and assets than foreigners want to buy of its own — and the exchange rate falls until foreigners' willingness to hold its assets exactly plugs the gap.

Step 3: under a fixed rate. The central bank pegs the price, so the market cannot clear on price. If private demand for the currency falls short of private supply, the central bank buys the excess with foreign exchange reserves. Reserves fall. But reserves are themselves a financial account item. So the identity still holds — it holds because of an official transaction rather than a price adjustment. This is the entire mechanism of a peg, and it is why pegs are constrained: reserves are finite.

#2.6 What a "deficit" actually means — three equivalent statements

Statement 1: a deficit is a net sale of assets. From the identity with the capital account and errors set aside, CA = −FA. A current account deficit is identically a net financial inflow: foreigners are acquiring more claims on you than you are acquiring on them.

Statement 2: a deficit is spending in excess of income. Start from national income accounting:

Y = C + I + G + X − M

Define domestic absorption A = C + I + G, that is, total domestic spending on goods and services. Then:

X − M = Y − A
CA ≈ Y − A     (adding net income and transfer flows)

A current account deficit means the country is absorbing more than it produces. This is the absorption approach, and it will do enormous work later, because it says immediately that any policy which does not change either output or absorption cannot change the current account.

Statement 3: a deficit is an excess of investment over saving. National saving is S = Y − C − G. Substituting into Y = C + I + G + NX:

S = I + NX
NX = S − I
CA = S − I     (adding net income flows)

A current account deficit means domestic investment exceeds domestic saving, and the shortfall is financed by foreign saving. This is the sharpest of the three, because it tells you that a deficit driven by high investment (building productive capacity) is a completely different economic event from a deficit driven by low saving (a consumption boom or a large fiscal deficit), even though the two look identical in the trade data.

DIAGNOSTIC RULE
Deficit + high investment  = borrowing to build. Usually benign.
Deficit + low saving       = borrowing to consume. Usually not.
Ask which one, every time. The number alone tells you nothing.

#2.7 The stock counterpart: the net international investment position

Flows accumulate into stocks. Running current account deficits year after year builds a negative net international investment position (NIIP): foreign-owned claims on you exceed your claims on foreigners.

At the end of 2025, the US NIIP was −$27.54 trillion: US-owned foreign assets of $42.96 trillion against foreign-owned US assets of $70.49 trillion (BEA, U.S. International Transactions and International Investment Position, 4th Quarter and Year 2025, released 25 March 2026). The US current account deficit for 2025 was $1.12 trillion, or 3.6% of GDP, narrowed from 4.0% in 2024.

China sits on the other side: a current account surplus of $735 billion, or 3.8% of GDP, in 2025, and a net foreign investment position of roughly $4 trillion, about 21% of GDP — the world's second-largest net creditor after Germany (BOFIT, Weekly Review, 2026, citing SAFE).

Now use China to see the identity working in live data. In 2025 China ran that $735bn current account surplus and simultaneously recorded net financial outflows of $774bn, including roughly $425bn of portfolio outflows and a $293bn deficit on "other investment"; reserves fell $47bn to $3.74 trillion. The surplus and the outflow very nearly offset, with the residual falling into net errors and omissions. A surplus is not a pile of cash. It is a purchase of foreign assets, and China spent 2025 buying them.

#2.8 Boundary case: net errors and omissions

The residual is not noise to be ignored — it is information. Persistently large negative errors and omissions in a country with capital controls is the classic statistical signature of unrecorded capital flight: money leaving through channels the statisticians cannot see (over-invoiced imports, under-invoiced exports, informal transfer networks). When you see it, the recorded financial account is understating outflows. This is a legitimate and sophisticated evaluation point about the reliability of balance of payments data for developing economies, and it directly serves the WEC14 examiner's repeated demand that candidates be "critical of the evidence".

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#3. Exchange rate systems

#3.1 Three measures of an exchange rate

Before comparing systems, distinguish three different numbers, all called "the exchange rate".

Nominal bilateral rate. The price of one currency in terms of another: $1.30 per £1. Useful for a single trade relationship, misleading for the economy as a whole, because a currency can rise against one partner and fall against another on the same day.

Nominal effective exchange rate (NEER). A trade-weighted index of the bilateral rates against all significant partners. If 40% of trade is with the euro area and 15% with the US, those weights apply. This is the number to use for "did the currency rise or fall" at national level.

NEER = Σ wᵢ × (bilateral index against currency i)
where wᵢ = country i's share of the home country's trade, Σ wᵢ = 1

Real effective exchange rate (RER or REER). The NEER adjusted for relative price levels. This is the only one of the three that measures competitiveness.

DERIVATION OF THE REAL EXCHANGE RATE

Q = (e × P) / P*

e  = foreign currency per unit of domestic currency
P  = domestic price level
P* = foreign price level

Numerator (e × P) = the domestic basket, valued in foreign currency.
Denominator P*    = the foreign basket, valued in foreign currency.
Q therefore = the price of home goods relative to foreign goods,
              measured in a single currency.
Q rises  = real appreciation = home goods relatively dearer = less competitive.
Q falls  = real depreciation = home goods relatively cheaper = more competitive.

The immediate payoff: a nominal depreciation only improves competitiveness if it is not eaten by relatively higher domestic inflation. In log-change form:

%ΔQ ≈ %Δe + π − π*

If a country depreciates 10% and then runs inflation 10 percentage points above its partners, %ΔQ = −10 + 10 = 0. The real exchange rate is exactly where it started. All the pain, none of the gain. This one equation destroys the naive case for devaluation and should appear in any evaluation of it.

#3.2 Floating exchange rates

Under a free float, the rate is set entirely by private demand and supply for the currency. The central bank does not intervene and holds no exchange rate target.

Mechanics: if demand for the currency exceeds supply at the current rate, the price rises until they are equal. Because the price adjusts, quantities always clear, and therefore — as derived in §2.5 — the balance of payments automatically sums to zero without any official financing.

Advantages, each with its mechanism:

• Monetary policy independence. Because the central bank has no exchange rate commitment, it can set interest rates for domestic objectives. (Derived formally in §3.5.)
• Automatic adjustment. A current account deficit puts net supply pressure on the currency, which depreciates, which — if elasticities are sufficient — corrects the deficit. Note the conditional; it is the whole of §5.
• No reserves needed. No commitment means nothing to defend.
• Insulation from external shocks. A fall in export demand causes a depreciation rather than a fall in output.

Disadvantages:

• Volatility. Currency markets turn over vastly more in financial transactions than in trade transactions, so the rate is driven by portfolio decisions, not trade fundamentals.
• Uncertainty for traders and investors, raising hedging costs and deterring long-horizon FDI.
• Imported inflation transmitted quickly through a depreciation.
• No discipline. Nothing forces the government to control inflation, because the currency can always fall.

#3.3 Fixed exchange rates, and how a peg is actually defended

Under a fixed rate, the government or central bank announces a parity against another currency (or a basket) and commits to maintain it, usually within a narrow band.

Terminology matters for marks:

Under a FIXED rate:  a deliberate policy fall = DEVALUATION
                     a deliberate policy rise = REVALUATION
Under a FLOAT:       a market-driven fall     = DEPRECIATION
                     a market-driven rise     = APPRECIATION
Using the wrong pair is a precision error the mark scheme notices.

Defending a weak currency (market wants the currency lower than the peg). Three instruments, in ascending order of pain:

1. Buy the domestic currency with foreign exchange reserves. The central bank becomes the residual buyer, absorbing the excess supply. Direct, immediate, and bounded by the stock of reserves. This is the binding constraint.
2. Raise domestic interest rates. This raises the return on domestic-currency assets, attracting capital inflows and raising demand for the currency (mechanism derived in §4.2). Unbounded in principle, but it inflicts recession, raises mortgage and government borrowing costs, and stresses banks.
3. Impose capital controls. Legally restrict residents from converting and moving funds out. Effective in the short run, corrosive in the long run: it deters the FDI that the country wants, and encourages evasion (which shows up as errors and omissions).

Defending a strong currency (market wants the currency higher than the peg or ceiling). The central bank sells its own currency and buys foreign assets. It can print its own currency without limit, so this defence is unbounded in the direction of quantity. But it is not costless: buying foreign assets expands the domestic money supply, which is inflationary unless sterilised, and it accumulates a foreign asset portfolio that makes a large capital loss the moment the peg breaks.

THE FUNDAMENTAL ASYMMETRY
Defending a WEAK currency: limited by reserves. You can run out.
Defending a STRONG currency: unlimited in quantity. You cannot run out.
But: the strong-currency defence imports inflation and risks huge losses.
Speculators know both facts. They attack the weak side.

#3.4 Boundary case 1: Black Wednesday, 16 September 1992

The UK joined the European Exchange Rate Mechanism in October 1990 at a central parity against the Deutsche Mark. ERM membership had allowed base rates to fall from 15% to 10% over the preceding eighteen months. But German reunification forced the Bundesbank to keep German rates high, while the UK was in recession and needed lower rates. The two objectives were incompatible.

On 16 September 1992 the UK attempted all three defences at once: heavy reserve sales, an announced base rate rise from 10% to 12% with a further rise to 15% announced for the following day, and public commitment. It failed within hours. The Bank of England's own account records simply that "on 16 September, in exceptionally turbulent market conditions… the United Kingdom suspended sterling's membership of the ERM" (Bank of England, Quarterly Bulletin, 1992 Q4).

The lesson is not "speculators are powerful". It is structural: a peg fails when the interest rate required to defend it is inconsistent with the domestic economy. Markets do not attack pegs they believe the government will pay to defend; they attack pegs where the domestic cost of defence is visibly higher than the government can bear. The announced 15% rate was not credible precisely because a recessionary economy could not sustain it, and everyone could see that.

#3.5 Boundary case 2: the Swiss franc ceiling, 2011–2015

The mirror image. In September 2011, with safe-haven flows driving the franc up and Swiss exporters and tourism suffering, the Swiss National Bank announced a minimum exchange rate of CHF 1.20 per euro — a ceiling on the franc, not a floor. It committed to buy "unlimited quantities" of foreign currency to enforce it, and — per §3.3 — that commitment was credible, because printing francs is costless.

It held for over three years, and then the SNB abandoned it on 15 January 2015. On the announcement the franc surged by roughly 30% intraday against the euro before settling around 13% higher at about CHF 1.040 per euro; the Swiss benchmark equity index fell more than 10% at its worst; Swatch Group shares fell about 15% (CNBC, 15 January 2015).

Why abandon a defence you cannot lose on quantity? Because you can lose on the balance sheet and on inflation. Holding the ceiling meant accumulating euro assets on a scale that dwarfed Swiss GDP, at a moment when the ECB was about to begin large-scale asset purchases, implying still more pressure. The SNB chose one large loss over an unbounded and growing one.

RULE FROM THE TWO CASES
A peg is a promise. Its value is the market's estimate of your willingness to pay.
The UK could not pay in interest rates. The SNB would not pay in balance sheet.
Both pegs broke. Neither broke because of arithmetic.

#3.6 Managed floating and intermediate regimes

Most currencies are neither cleanly floating nor rigidly fixed.

Managed float ("dirty float"). The rate is market-determined, but the central bank intervenes discretionarily to smooth volatility or lean against moves it considers excessive, without announcing a target. Most large emerging economies operate this way.

Crawling peg. A fixed rate that is adjusted at a pre-announced rate, typically to offset an inflation differential. This is relative PPP (§4.3) used as a policy rule.

Currency board. A hard peg backed by a legal requirement to hold foreign reserves covering the entire monetary base, with no discretionary monetary policy. Hong Kong is the standing example.

Monetary union. The limiting case: the exchange rate is abolished by adopting a common currency. Members give up the exchange rate as an adjustment mechanism entirely, which is why an asymmetric shock in a monetary union must be absorbed by wages, prices, migration or fiscal transfers instead.

#3.7 The impossible trinity — derived

The choice between regimes is not free. It is constrained by a result that can be derived in three lines from the arbitrage condition in §4.2.

Under free capital mobility, investors equalise expected returns across currencies:

i = i* + (expected % depreciation of the domestic currency)

Now suppose the exchange rate is credibly and permanently fixed. Then the expected depreciation is zero, so:

i = i*

The domestic interest rate is pinned to the foreign one. There is no monetary policy left to conduct. Therefore:

THE IMPOSSIBLE TRINITY (Mundell–Fleming)
You may have any TWO of the following three. Never all three.
  (1) A fixed exchange rate
  (2) Free movement of capital
  (3) An independent monetary policy

Fixed rate + free capital → no monetary independence (Hong Kong; the eurozone)
Fixed rate + monetary independence → capital controls required (China historically)
Free capital + monetary independence → the rate must float (UK, US, Japan)

This is not a list to memorise. It is a theorem, and the proof is the arbitrage condition. Use it to explain why a country that wants to defend a peg must surrender its interest rate to the defence — which is exactly what killed sterling's ERM membership in 1992.

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#4. Exchange rate determination

#4.1 Deriving the currency market from first principles

The market for pounds is a market like any other. What makes it unusual is that the demand and supply curves are derived from other markets — the market for British exports, and the market for British assets.

Deriving the demand curve for sterling. Who wants pounds? Anyone who must make a payment in pounds. That is:

• foreign buyers of UK exports of goods and services;
• foreign recipients of nothing — payers of income and transfers to UK residents;
• foreign investors buying UK assets (gilts, equities, property, companies).

Now ask why the curve slopes downward. Take the export channel. A UK export has a price P_x fixed in sterling. Its price to an American buyer is P_x ÷ e where e is dollars per pound — no: it is P_x × e dollars. If e falls from $1.50 to $1.35, a £20,000 car falls from $30,000 to $27,000. Americans buy more cars. Each car requires £20,000 to be bought. So a lower e means more pounds demanded, provided the demand for UK exports has some positive elasticity. The demand curve for sterling slopes downward.

Note the condition. If foreign demand for UK exports were perfectly inelastic — say the UK exported one unique medicine with no substitute — then a lower e would not change the number of units sold, and the quantity of pounds demanded would be unchanged. The demand curve for sterling would be vertical. The downward slope of currency demand is inherited from the elasticity of export demand. Hold that thought; it becomes Marshall-Lerner.

Deriving the supply curve for sterling. Who supplies pounds? UK residents who need foreign currency:

• UK importers of goods and services;
• UK residents paying income and transfers abroad;
• UK investors buying foreign assets.

Take the import channel. A US-made good has a price P_m fixed in dollars. Its sterling price is P_m ÷ e. If e rises from $1.30 to $1.50, a $600 device falls from £461 to £400. UK buyers buy more of them. Each purchase requires pounds to be sold for dollars. So a higher e means more pounds supplied — provided UK import demand has some positive elasticity. The supply curve slopes upward.

But here the condition is much sharper, and this is the single most underappreciated point in the topic.

DERIVATION: WHY THE SUPPLY OF STERLING CAN BEND BACKWARDS

Quantity of pounds supplied to buy imports
   = (sterling value of imports)
   = (P*ₘ / e) × Qₘ

Take proportional changes, with P*ₘ fixed:
   %Δ(pounds supplied) = −%Δe + %ΔQₘ

Let ηₘ = elasticity of import demand (a positive number), so
   %ΔQₘ = ηₘ × %Δe     (a rise in e cuts the sterling price, raising Qₘ)

Substituting:
   %Δ(pounds supplied) = (ηₘ − 1) × %Δe

If ηₘ > 1: e rises → more pounds supplied. Supply curve slopes UP.
If ηₘ < 1: e rises → FEWER pounds supplied. Supply curve slopes BACK.
If ηₘ = 1: supply is vertical.

That result is doing enormous work. It says that when import demand is inelastic, a stronger pound means the country spends fewer pounds in total on imports, because the price falls faster than the volume rises. Read it in reverse — a weaker pound with inelastic import demand means more pounds spent on imports — and you have already derived half of the Marshall-Lerner condition, before Marshall-Lerner has been mentioned.

Equilibrium. The rate settles where the quantity of pounds demanded equals the quantity supplied. Every determinant below works by shifting one of these two curves, and the exam expects you to say which curve, in which direction, and why.

DIAGRAM DISCIPLINE (worth real marks)
Vertical axis: exchange rate, labelled with units, e.g. "$ per £".
Horizontal axis: "Quantity of £ traded per period".
Two curves: D£ and S£. Label the shifted curve D£₁ or S£₁.
Mark e₁ and e₂ on the vertical axis with a dashed line.
Never draw an unlabelled axis. Examiner reports flag this every series.

#4.2 Determinant 1: relative interest rates — derived

The standard claim is "higher interest rates attract hot money, so the currency appreciates". True, but it explains nothing about magnitude or about the cases where it fails. Here is the actual mechanism.

Consider an investor with £1 and a one-year horizon, choosing between a UK deposit at rate i and a US deposit at rate i*. Let e be dollars per pound today and eᵉ the rate expected in one year.

DERIVATION: UNCOVERED INTEREST PARITY

Option A — stay in sterling:
   End with (1 + i) pounds.

Option B — go to dollars and back:
   Convert:  £1 → e dollars
   Invest:   e × (1 + i*) dollars after one year
   Convert back at the expected rate:
             e × (1 + i*) / eᵉ pounds

Assume risk neutrality, free capital mobility, no transaction costs.
Arbitrage drives the two to equality:

   1 + i = e (1 + i*) / eᵉ

Rearranged:
   eᵉ / e = (1 + i*) / (1 + i)

Log-linear approximation for small rates:
   i − i* ≈ − (eᵉ − e)/e = the expected % DEPRECIATION of sterling

Read the result carefully. It does not say a higher UK interest rate makes sterling strong forever. It says a higher UK interest rate must be accompanied by an expected future depreciation of exactly that size. Otherwise there would be a free lunch, and there is not.

So how does an interest rate rise cause an appreciation? Through the timing. Suppose the market's expected long-run rate eᵉ is anchored by fundamentals (purchasing power parity, §4.3) at $1.2500. UK rates then rise unexpectedly from 2% to 5% while US rates stay at 2%.

WORKED EXAMPLE: OVERSHOOTING

Before:   i = 2%, i* = 2%.  eᵉ/e = 1.02/1.02 = 1.  So e = eᵉ = $1.2500.
After:    i = 5%, i* = 2%.  eᵉ/e = 1.02/1.05 = 0.97143
          Therefore e = eᵉ / 0.97143 = 1.2500 / 0.97143 = $1.2867

Sterling JUMPS from $1.2500 to $1.2867 — a 2.94% appreciation on impact.
It is then expected to DEPRECIATE back to $1.2500 over the year, at ~2.9%,
exactly offsetting the 3-point interest advantage.

This is Dornbusch's overshooting result, and it explains something the naive story cannot: why currencies move so violently on interest rate news. The entire future path of the interest differential has to be capitalised into today's spot rate, because that is the only free variable. It also explains why exchange rates are far more volatile than goods prices — goods prices are sticky, so the exchange rate must do all the adjusting.

The evaluation payoff. The size of the appreciation depends on how persistent the market thinks the rate differential is. A rate rise expected to be reversed in three months moves the currency far less than the same rise expected to last three years. "Higher interest rates cause an appreciation" is a two-stage chain. "A higher interest rate raises the expected return on sterling assets; arbitrage requires an offsetting expected depreciation; with the long-run rate anchored, spot sterling must jump immediately, by more the longer the differential is expected to persist" is a four-stage chain. That is the difference between Level 2 and Level 4.

#4.3 Determinant 2: relative inflation and purchasing power parity — derived

Start with the law of one price. Consider a single, homogeneous, freely tradable good — say a tonne of a standard grade of copper. Let S be the domestic-currency price of foreign currency (so S = 1/e), P the domestic price and P* the foreign price.

DERIVATION: THE LAW OF ONE PRICE

Suppose  P < S × P*  (the good is cheaper at home when both are
                      measured in domestic currency).

Then an arbitrageur can:
   buy one unit at home for P,
   ship and sell abroad for P*, receiving S × P* in domestic currency,
   profit = S P* − P > 0, riskless.

Everyone does this. Domestic demand rises → P rises.
Foreign supply rises → P* falls. Also selling foreign currency → S falls.
Arbitrage continues until the profit vanishes:

   P = S × P*                                    [LAW OF ONE PRICE]

ASSUMPTIONS THIS RESTS ON (each one is a later boundary case):
   • zero transport costs
   • no tariffs, quotas or other barriers
   • the good is identical and tradable
   • competitive markets, no pricing-to-market

From one good to the whole basket: absolute PPP. Now assume every good in the consumption basket satisfies the law of one price, and that the domestic and foreign baskets have identical composition and weights. Then the price levels must satisfy the same relation:

P = S × P*      ⟹      S = P / P*                [ABSOLUTE PPP]

Equivalently, in the notation of §3.1, the real exchange rate Q = e P / P* equals 1. Absolute PPP is the claim that the real exchange rate is always one.

Relative PPP. Absolute PPP is far too strong (see §4.4). But a weaker version survives. Take logarithms of S = P/P* and differentiate with respect to time:

ln S = ln P − ln P*
%ΔS = π − π*                                     [RELATIVE PPP]

In the e-convention (foreign currency per unit of domestic):
%Δe = π* − π

A currency depreciates at the rate by which its inflation exceeds
its trading partners'. That is the whole theory.

The economic mechanism, stated as a chain you can write in an exam: if domestic inflation exceeds foreign inflation, domestic goods become relatively expensive at the unchanged exchange rate; foreign buyers switch away from domestic exports, reducing demand for the currency; domestic buyers switch toward now-relatively-cheap imports, increasing supply of the currency; both curves move against the currency; it depreciates until relative prices in a common currency are restored.

Worked example. Country A has inflation of 12%; its trading partners average 3%. Relative PPP predicts a depreciation of approximately 12 − 3 = 9% per year. If A instead holds a fixed nominal peg, its real exchange rate appreciates by about 9% per year — it becomes 9% less competitive annually, with no change in productivity, technology or effort. After three years, cumulative real appreciation is 1.09³ − 1 = 29.5%. That is a competitiveness crisis manufactured entirely by an inconsistent policy mix.

Real-world test: Egypt, March 2024. Egypt held the pound at roughly EGP 30.9 per US dollar for about a year while running inflation of approximately 30% against US inflation of a few per cent — an inflation gap of the order of 26 percentage points. A parallel-market rate of around EGP 45 per dollar had opened up, which is what a suppressed price does. On 6 March 2024 the central bank allowed the pound to move and it fell to about EGP 42 per dollar — a 26.5% fall in the value of the pound — alongside an unscheduled 600 basis point interest rate rise to 27.25%, and an expanded IMF programme of $8bn (Gulf News and Al Jazeera, 6 March 2024).

The size of the devaluation is strikingly close to the accumulated inflation differential. That is relative PPP being enforced by the market after being resisted by policy. The general lesson: you cannot peg a nominal exchange rate and run an independent inflation rate. One of the two must give.

#4.4 Boundary cases: where PPP breaks

PPP is an anchor, not a forecast. Deviations are large and persistent. Four reasons, each of which is a usable evaluation point.

(1) Non-tradables. A haircut, a rented flat, a restaurant meal, a doctor's appointment — these cannot be arbitraged across borders. They form a large share of the consumer price index, in most economies well over half. The law of one price never applies to them, so the aggregate price levels need never converge.

(2) Transport costs, tariffs and non-tariff barriers. Arbitrage is only profitable if the price gap exceeds the cost of moving the good. This creates a band of no arbitrage around PPP, wider for heavy, perishable or heavily protected goods. Cement and fresh milk deviate from PPP far more than gold or crude oil.

(3) Imperfect competition and pricing-to-market. Firms with market power set different prices in different countries and absorb exchange rate movements in their margins rather than passing them through. A German carmaker facing a euro appreciation may cut its euro margin to hold its US dollar sticker price, precisely to protect market share. This is why exchange rate pass-through is typically well below 100% and is one of the strongest arguments against expecting a depreciation to work quickly.

(4) The Balassa-Samuelson effect — derived. This is the deepest of the four, and it is derivable in six lines.

DERIVATION: BALASSA-SAMUELSON

Assume:
  • Two sectors: tradables (T) and non-tradables (N).
  • Labour is mobile between sectors WITHIN a country, so one wage W.
  • Labour is NOT mobile between countries.
  • Competition sets price = unit cost, so Pᵢ = W / Aᵢ where Aᵢ = productivity.
  • The law of one price holds for tradables only:  P_T = S × P*_T.
  • The general price level is P = (P_T)^α (P_N)^(1−α).

Step 1. From P_T = W/A_T and P_T = S P*_T:
        W = A_T × S × P*_T
        (Wages are set by TRADABLE-sector productivity.)

Step 2. Non-tradable prices:
        P_N = W / A_N = S × P*_T × (A_T / A_N)

Step 3. The overall price level:
        P = (S P*_T)^α × (S P*_T · A_T/A_N)^(1−α)
          = S × P*_T × (A_T / A_N)^(1−α)

Step 4. The real exchange rate, home relative to foreign:
        P / (S P*) = (A_T/A_N)^(1−α) ÷ (A*_T/A*_N)^(1−α)

CONCLUSION: the country with the HIGHER ratio of tradable to
non-tradable productivity has the HIGHER price level in a
common currency. Its currency will look "overvalued" on PPP,
permanently, with no misalignment whatsoever.

Why does the ratio A_T/A_N rise with development? Because productivity growth is concentrated in tradables. You can automate car assembly, semiconductor fabrication and chemical processing; you cannot automate a haircut, a nurse's shift or a restaurant table. Rich countries are hugely more productive than poor ones in manufacturing and only modestly more productive in services. So rich-country wages — set by tradable productivity — are high, and those high wages make their non-tradables expensive.

Empirical check: the Big Mac index. A Big Mac is a bundle of tradables (beef, wheat, packaging) and non-tradables (rent, labour, local utilities), which makes it a near-perfect Balassa-Samuelson thermometer.

Source: World Population Review compilation of The Economist's Big Mac index, accessed June 2026. The Economist introduced the index in 1986.

The ordering is almost exactly the ordering of GDP per capita. The naive PPP reading — "the Swiss franc is 38% overvalued, the Indian rupee 55% undervalued" — is largely wrong. Most of that spread is Balassa-Samuelson, not misalignment. This is the single best evaluation point available on PPP, and almost no candidate makes it.

#4.5 Determinant 3: the current account position

Mechanism: a current account deficit means, by construction, that residents are supplying more domestic currency to pay for imports, income and transfers than foreigners are demanding to pay for exports. In the currency market this is a rightward shift of supply relative to demand, so the currency depreciates.

But this is the determinant candidates most over-weight, and the mark schemes explicitly evaluate against it: "Current account is relatively minor because other capital flows are much more significant" (Pearson WEC14 mark scheme, October 2024 Q10 indicative content).

The reason is a matter of scale. Global foreign exchange turnover is dominated overwhelmingly by financial transactions, not by trade settlement. A country's annual trade flows are a small fraction of the daily flow through its currency. So on any horizon shorter than several years, the exchange rate is set by portfolio decisions, and the current account matters mainly through what it signals about sustainability rather than through the direct flow.

RULE
Short run: capital flows dominate. Interest rates, risk, expectations.
Long run: trade fundamentals dominate. PPP and competitiveness.
Say which horizon you mean. Examiners reward the distinction explicitly.

#4.6 Determinant 4: relative growth and income

Mechanism: import demand is a function of domestic income. If the marginal propensity to import is m, then faster domestic growth raises imports by m × ΔY, increasing the supply of domestic currency and depreciating it. Symmetrically, faster growth in trading partners raises their demand for your exports and appreciates your currency.

The counter-mechanism, and this is where the good answers live: faster growth also raises the expected return on domestic capital, attracting FDI and portfolio equity inflows, which appreciates the currency. The net effect depends on which channel dominates — the trade channel or the capital channel.

This is a genuine ambiguity, not a fudge, and it is exactly what the mark scheme means by "different factors will be important for different countries". For a fast-growing economy with an attractive equity market, the capital channel usually wins. For a fast-growing economy with a high marginal propensity to import capital equipment and no deep financial market, the trade channel usually wins.

#4.7 Determinant 5: capital flight, political risk and default risk

Mechanism, in four stages: perceived risk of expropriation, default, redenomination or instability rises → the risk premium demanded on domestic-currency assets rises → at the existing exchange rate the expected return net of risk is now too low → residents and foreigners sell domestic assets and buy foreign ones → supply of domestic currency shifts right, demand shifts left → sharp depreciation.

Formally, add a risk premium ρ to the parity condition of §4.2:

i − i* = expected depreciation + ρ

Note what this does. For a given interest differential, a rise in ρ requires a larger expected depreciation — which, with the long-run rate anchored, is delivered by an immediate fall in the spot rate. Risk premia move exchange rates without any change in interest rates at all.

Capital flight is self-reinforcing, and that matters for the answer: the depreciation raises the domestic-currency value of foreign-currency debt, worsening balance sheets, raising default risk, raising ρ further. This is the mechanism of a currency crisis, and it is why crises are non-linear.

#4.8 Determinant 6: speculation and expectations

Speculators do not trade currencies for trade or long-term investment; they trade on the expected path of the price. Mechanism: if speculators expect a currency to fall, they sell it now, which makes it fall now. The expectation is partly self-fulfilling.

This creates the possibility of multiple equilibria. Suppose a peg is sustainable if nobody attacks and unsustainable if everybody does — because a large attack forces the interest rate defence to a level that breaks the domestic economy, which then makes abandonment optimal. Then "everybody attacks" and "nobody attacks" are both self-consistent outcomes. Which one occurs depends on beliefs, not on fundamentals alone. This is why currency crises can appear to come from nowhere, and why credibility is an economic asset rather than a rhetorical one.

The clearest single-day demonstration is the UK referendum result. Sterling traded as high as $1.50 on 23 June 2016 and fell to an intraday low of $1.3224 on 24 June 2016, closing at $1.3632 — a fall of 8.33% from the previous close, and the worst daily fall in records dating back to 1971 (City A.M., 24 June 2016). Nothing measurable in UK trade, productivity or interest rates changed in those twenty-four hours. What changed was the expected future path of everything.

#4.9 Determinant 7: global factors

Four channels, each worth a chain:

The global dollar cycle. When US monetary policy tightens or global risk appetite falls, capital moves into dollar assets regardless of conditions elsewhere. Many currencies depreciate simultaneously against the dollar for reasons wholly external to the countries concerned. This is the single most common cause of an emerging-market depreciation, and it is not the country's fault.

Commodity prices. For commodity exporters, the export price is set on world markets and the currency tracks it — these are "commodity currencies". Nigeria's dependence is extreme: petroleum products accounted for 88.26% of Nigeria's total export value in 2024, with agriculture at 5.73% (National Bureau of Statistics data, 2024). A country with that structure does not have an independent exchange rate; it has an oil price with a flag on it.

Risk-off episodes. In global stress, capital flows to perceived safe havens — historically the US dollar, Swiss franc and Japanese yen — regardless of their current account positions. Note the awkward fact for simple models: Japan combines the highest government debt ratio in the developed world with a currency that appreciates in crises. Pearson's own mark scheme uses this as a model evaluation point: "in Japan's case, the national debt of over 230% has not prevented an appreciation of its currency" (WEC14 mark scheme, October 2024).

Quantitative easing. Large-scale central bank asset purchases lower domestic yields and expand the monetary base, both of which reduce the relative return on domestic assets. QE is a currency depreciation instrument even when it is not described as one, and the WEC14 specification lists it explicitly under government intervention in exchange rates.

#4.10 Boundary case: when higher interest rates weaken a currency

The textbook says higher rates strengthen a currency. There are three well-defined situations where they do not, and each is a high-value evaluation point.

(1) The credibility channel dominates. An emergency rate rise can be read as a signal that the authorities are panicking, that the situation is worse than disclosed, or that a default is nearer. In the parity condition, i rises but ρ rises by more, so the currency falls. Turkey is the standing case in reverse: the central bank cut rates into high inflation in 2021, and the lira collapsed; the subsequent reversal took the policy rate from 15% in June 2023 to 40% in November 2023 and to 50% in March 2024 (CNBC, 21 March 2024). The tightening was not primarily about the arithmetic of the interest differential — it was about restoring the credibility term.

(2) The growth channel dominates. Very high rates can be expected to cause a deep recession, which lowers the expected future return on domestic equity and property, and lowers expected future tax revenue relative to debt. If the expected long-run rate eᵉ falls by more than the interest differential rises, the spot rate falls. This is what happened to sterling on 16 September 1992: announcing 15% base rates did not save the pound, because a 15% base rate in a recession was not survivable and everyone knew it.

(3) The fiscal solvency channel dominates. If government debt is large and mostly short-maturity, a rate rise raises debt service costs immediately, worsening the fiscal position and raising default risk. The UK's September 2022 episode is a mild developed-country version: after the mini-budget of 23 September 2022 the 30-year gilt yield rose about 120 basis points in three days, sterling fell to an all-time low against the dollar in intraday trading on 26 September, and the Bank of England had to conduct temporary long-dated gilt purchases from 28 September to 14 October 2022, ultimately buying £19.26bn of an allocated £65bn (EFG International; Bank of England). Higher yields and a weaker currency moved together — the opposite of the textbook relationship — because both were pricing the same fiscal risk.

RULE: THE PARITY CONDITION WITH RISK
i − i* = expected depreciation + ρ
A rate rise raises i. It may also raise ρ.
The currency strengthens only if Δi > Δρ.
Always ask: does this rate rise look like strength or like distress?

---

#5. The effects of exchange rate changes

#5.1 First-round price effects

A depreciation changes prices before it changes anything else. Get these two lines exactly right, because every subsequent result is built on them.

DERIVATION: THE TWO PRICE EFFECTS

e = foreign currency per unit of domestic currency.
Assume EXPORT prices are set in DOMESTIC currency at Pₓ.
Assume IMPORT prices are set in FOREIGN currency at P*ₘ.
(Both assumptions are relaxed in §5.6.)

Foreign-currency price of exports  = Pₓ × e
   → e falls 10%, so this falls 10%. Exports get CHEAPER abroad.

Domestic-currency price of imports = P*ₘ / e
   → e falls 10%, so this rises by 1/0.9 − 1 = 11.11%.
     Imports get DEARER at home.

NOTE THE ASYMMETRY. A 10% depreciation cuts export prices by 10%
but raises import prices by 11.11%, not 10%. The reciprocal is not
the same as the negative. Use exact arithmetic in worked answers.

#5.2 The two elasticities, defined precisely

ηₓ = price elasticity of foreign demand for exports
   = − %Δ(export volume) ÷ %Δ(foreign-currency price of exports)

ηₘ = price elasticity of domestic demand for imports
   = − %Δ(import volume) ÷ %Δ(domestic-currency price of imports)

BOTH ARE WRITTEN AS POSITIVE NUMBERS by the minus sign.
η > 1 is elastic. η < 1 is inelastic.

#5.3 Deriving the Marshall-Lerner condition

We now derive the threshold. The current account balance, measured in domestic currency, is:

CA = (Pₓ × Qₓ)  −  (P*ₘ / e) × Qₘ
   =    X       −      M

Step 1: what happens to export revenue X?

X = Pₓ × Qₓ. The domestic price Pₓ is unchanged by assumption. So the entire change in X comes from the volume:

%ΔX = %ΔQₓ = ηₓ × [ −%Δ(foreign price of exports) ] = −ηₓ × %Δe

With a depreciation, %Δe < 0, so %ΔX > 0 for any ηₓ > 0.

Export revenue measured in domestic currency always rises after a depreciation, however inelastic foreign demand is, provided it is not perfectly inelastic. The domestic price per unit is unchanged and the volume goes up. There is no adverse case on the export side.

This is worth pausing on. The entire risk in Marshall-Lerner sits on the import side. Most students believe the opposite.

Step 2: what happens to import expenditure M?

M = (P*ₘ / e) × Qₘ. Two things change: the domestic-currency price rises, and the volume falls.

%ΔM = %Δ(P*ₘ/e) + %ΔQₘ
    = −%Δe        + %ΔQₘ

And   %ΔQₘ = −ηₘ × %Δ(domestic price of imports) = −ηₘ × (−%Δe) = ηₘ × %Δe

So:   %ΔM = −%Δe + ηₘ %Δe = (ηₘ − 1) × %Δe

Now read the sign, with %Δe < 0 (a depreciation):

ηₘ > 1  →  (ηₘ − 1) > 0  →  %ΔM < 0.  Import spending FALLS.  Good.
ηₘ = 1  →  %ΔM = 0.       Import spending UNCHANGED.
ηₘ < 1  →  (ηₘ − 1) < 0  →  %ΔM > 0.  Import spending RISES.   Bad.

The intuition, in one sentence: if import volumes fall by proportionally less than import prices rise, the country ends up spending more domestic currency on a smaller quantity of imports.

Step 3: combine.

ΔCA = ΔX − ΔM
    = X·(%ΔX) − M·(%ΔM)
    = X·(−ηₓ %Δe) − M·((ηₘ − 1) %Δe)
    = −%Δe · [ X·ηₓ + M·ηₘ − M ]

Write the depreciation as %Δe = −d, with d > 0. Then:

    ΔCA = d · [ X·ηₓ + M·ηₘ − M ]

ΔCA > 0   ⟺   X·ηₓ + M·ηₘ > M
          ⟺   (X/M)·ηₓ + ηₘ > 1                    [GENERAL FORM]

Step 4: impose the balanced-trade assumption. If the current account starts in balance, X = M, so X/M = 1:

╔═══════════════════════════════════════════════════════════╗
║   THE MARSHALL-LERNER CONDITION                           ║
║                                                           ║
║   A depreciation improves the current account if and      ║
║   only if      ηₓ + ηₘ  >  1                              ║
╚═══════════════════════════════════════════════════════════╝

That is the derivation. The threshold is 1 rather than 0 because of the unit-value effect on imports: the "−1" in the general form is precisely the extra domestic currency spent per unit of imports at the higher import price. Marshall-Lerner is not a mystical constant; it is the arithmetic of a price rise fighting a volume fall.

#5.4 The full worked case: watching the sign flip

Country A. Initial exports £100bn, initial imports £100bn — a balanced current account. The currency depreciates 10%, from $1.50 per £1 to $1.35 per £1.

PRICE CHANGES
Foreign-currency export price:  ×(1.35/1.50) = 0.9000  →  −10.00%
Domestic-currency import price: ×(1.50/1.35) = 1.1111  →  +11.11%

Case 1: elastic demand. ηₓ = 0.9, ηₘ = 0.7. Sum = 1.6 > 1.

The current account moves from balance to a £6.53bn surplus. Marshall-Lerner is satisfied; the depreciation works.

Case 2: inelastic demand. ηₓ = 0.3, ηₘ = 0.4. Sum = 0.7 < 1.

The current account moves from balance into a £3.17bn deficit. The depreciation made it worse. Export revenue rose, exactly as §5.3 Step 1 promised — but import spending rose by more, because volumes fell by 4.44% while prices rose by 11.11%.

Case 3: exactly on the threshold. ηₓ = 0.5, ηₘ = 0.5. Sum = 1.0.

The residual of £0.06bn is a second-order term; to a first-order approximation the effect is exactly zero. This numerically verifies the derivation. The threshold really is at ηₓ + ηₘ = 1, not at 0, not at 2, and not "when demand is elastic".

SUMMARY TABLE — SAME DEPRECIATION, THREE ELASTICITY PAIRS
ηₓ + ηₘ = 1.6  →  CA = +£6.53bn   improves
ηₓ + ηₘ = 1.0  →  CA = +£0.06bn   neutral
ηₓ + ηₘ = 0.7  →  CA = −£3.17bn   worsens
The direction of the price change was identical in all three.
The SIGN of the outcome was set entirely by the elasticities.

#5.5 Every assumption, and what breaks when you relax it

Marshall-Lerner is a conditional result. Here is every condition, what it is load-bearing for, and what happens when it fails.

Assumption 1: the current account starts in balance. Load-bearing for the specific threshold of 1. Relax it and the general form applies: (X/M)·ηₓ + ηₘ > 1.

WORKED EXAMPLE: STARTING FROM A DEFICIT

Initial X = £80bn, M = £100bn (deficit of £20bn, so X/M = 0.8).
Same 10% depreciation. Take ηₓ = 0.9, ηₘ = 0.2. Classic sum = 1.1 > 1.

Classic test:  ηₓ + ηₘ = 1.1 > 1                     → "passes"
General test:  0.8 × 0.9 + 0.2 = 0.92 < 1            → FAILS

Check it:
  Export revenue = 80 × 1.09                    = £87.20bn
  Import volume  = −0.2 × 11.11% = −2.22%       → index 97.78
  Import spend   = 100 × 1.1111 × 0.9778        = £108.64bn
  New CA = 87.20 − 108.64 = −£21.44bn
  Old CA = −£20.00bn
  The deficit WIDENED by £1.44bn.

This is the most important relaxation, and it is close to a scandal that textbooks omit it. The countries that depreciate are, almost by definition, the countries with deficits — and a deficit country needs a higher elasticity sum than 1 for depreciation to work. The export elasticity is discounted by the ratio X/M, because exports are a smaller base. The larger the initial deficit, the higher the bar.

Assumption 2: supply elasticities are infinite. Load-bearing for the claim that volume responses translate one-for-one into revenue. The derivation assumed that if foreign buyers want 9% more exports, domestic producers simply supply 9% more at the same domestic price. If the economy is at full capacity, they cannot. Instead Pₓ rises, which partly offsets the fall in the foreign-currency price, and the volume response is smaller than ηₓ implies.

Consequence: a depreciation works best when there is spare capacity, and worst at full employment. At full employment a depreciation is largely an inflation event rather than a trade event. This is a first-class evaluation line and it connects the topic to AD/AS: the effectiveness of expenditure-switching depends on the elasticity of SRAS.

Assumption 3: ceteris paribus. Load-bearing for attributing the whole change to the depreciation. In reality world income, competitors' prices, tariffs and commodity prices all move too. A depreciation during a global recession may coincide with a falling current account because export demand collapsed for unrelated reasons. Empirical tests of Marshall-Lerner are therefore genuinely hard, which is itself worth saying.

Assumption 4: full and immediate pass-through. Load-bearing for the price changes in §5.1. In practice firms with market power absorb part of the move in margins (pricing-to-market, §4.4). If pass-through to foreign export prices is only 60%, then a 10% depreciation cuts foreign prices by 6%, and the volume response is 40% smaller than the model predicts. Exporters gain margin rather than share. The current account still improves, but through a different and smaller channel.

Assumption 5: invoicing currency. Load-bearing for the direction of the valuation effect. The derivation assumed exports are invoiced in domestic currency and imports in foreign currency. In practice a very large share of world trade is invoiced in US dollars regardless of who is trading with whom. For a country whose exports are dollar-invoiced, a depreciation does not lower the foreign-currency price of its exports at all in the short run — it simply raises the domestic-currency revenue per unit. The volume channel is switched off and only the valuation channel remains.

Assumption 6: no balance-sheet effects. Load-bearing for the assumption that the depreciation is expansionary. Relaxed in §5.9.

Assumption 7: elasticities are constants. They are not; they rise with time. Relaxing this assumption is the J-curve, which we can now derive.

#5.6 Deriving the J-curve

The J-curve says that after a depreciation the current account first worsens and then improves, tracing a shape like the letter J. This is usually asserted with a hand-wave about "time lags". Here it is derived.

Step 1: in the immediate short run, both elasticities are approximately zero. Three reasons, and you should name them:

• Contract lags. Trade is transacted under contracts signed months earlier, specifying quantities and prices. Nothing about them changes when the exchange rate moves. Volumes are fixed by contract.
• Recognition and decision lags. Buyers must observe the price change, judge it permanent rather than noise, evaluate alternative suppliers, test quality, negotiate terms. This takes quarters, not days.
• Production and delivery lags. Even where an order is placed immediately, exporters need capacity, inputs, labour and shipping to fulfil it.

Step 2: substitute ηₓ = ηₘ = 0 into the general expression.

ΔCA = d · [ X·ηₓ + M·ηₘ − M ]
With ηₓ = ηₘ = 0:
ΔCA = d · [ 0 + 0 − M ] = − d·M

The current account worsens by (the size of the depreciation) × (the initial value of imports). This is a pure valuation effect: the same physical quantity of imports now costs more domestic currency, and the same physical quantity of exports earns the same domestic currency. There is no volume offset at all, because there has not yet been time for one.

Step 3: elasticities rise over time, as contracts are renegotiated, buyers search and switch, and exporters install capacity. The sum ηₓ + ηₘ climbs. When it crosses 1, ΔCA crosses zero. Thereafter the current account improves and eventually exceeds its starting point.

Step 4: the numbers. Same country as §5.4 — X = M = £100bn, 10% depreciation — with a plausible elasticity path.

Read the fourth column against the last. The sign of the current account flips exactly where the elasticity sum crosses 1, between the third and fourth rows. The J-curve is not a separate theory bolted onto Marshall-Lerner. The J-curve is Marshall-Lerner with the elasticities treated as functions of time. That single sentence, written in an exam, demonstrates a level of understanding that mark schemes describe as "accurate and precise… fully integrated".

DRAWING THE J-CURVE
Horizontal axis: time since the depreciation.
Vertical axis: current account balance (£bn, or % of GDP).
Mark the starting balance with a horizontal dashed line.
Curve dips below it first, crosses back through it, then rises above.
Label the trough. Label the crossing point "ηₓ + ηₘ = 1".
That label is what separates a decorative diagram from an analytical one.

How long is the dip? Empirically it is usually measured in quarters to a couple of years, and it varies with the composition of trade. Countries exporting differentiated manufactures with many substitutes have faster-rising elasticities than countries exporting commodities with fixed contracts, or importing food, fuel and medicine with no domestic substitutes. A country whose imports are necessities has a permanently low ηₘ and may never leave the bottom of the J.

#5.7 Effects on growth and employment

The chain, stated in full:

Depreciation
→ foreign-currency price of exports falls; domestic-currency price of imports rises
→ IF the Marshall-Lerner condition holds, net exports (X − M) rise
→ (X − M) is a component of AD, so AD shifts right
→ with spare capacity, real output rises along an upward-sloping SRAS
→ derived demand for labour rises in exporting and import-competing sectors
→ unemployment falls; the multiplier amplifies the initial injection
→ real GDP growth rises by [figure] and unemployment falls toward [figure]

Every link is required. Note in particular the conditional at stage two — an answer that jumps from "depreciation" to "AD rises" has skipped the entire analytical content of this chapter.

The size of the effect depends on:

• The share of trade in GDP. A 10% depreciation in an economy where exports are 60% of GDP is a far larger AD shock than in one where they are 12%.
• The multiplier, k = 1/(MPS + MPT + MPM). Note that a high marginal propensity to import both weakens the trade improvement and shrinks the multiplier.
• The position on SRAS. Near full capacity the increase in AD is absorbed by prices, not output.
• The import content of exports. In modern supply chains, exports embody imported components. If an exported car is 40% imported parts by value, the depreciation raises the cost of those parts and the net competitiveness gain is only about 60% of the headline. Highly integrated economies get much less from depreciation than the textbook implies.

#5.8 Effects on inflation

Two channels, and you should always name both.

Cost-push. The domestic-currency price of imported raw materials, energy, components and food rises mechanically — by 11.11% for a 10% depreciation, per §5.1. Firms' costs rise; SRAS shifts left; the price level rises and output falls. This is immediate and does not depend on any elasticity.

Demand-pull. If Marshall-Lerner holds, net exports and hence AD rise, pulling the price level up along SRAS. This is slower and does depend on the elasticities.

The size of the total effect depends on:

• Import penetration. The share of imports in the consumption basket and in intermediate inputs.
• Pass-through. How much of the exchange rate move reaches consumer prices, versus being absorbed in retailer and importer margins. Typically well under 100% and spread over a year or more.
• Second-round effects. Whether the initial price rise triggers wage claims. If it does, a wage-price spiral converts a one-off level shift into sustained inflation. If inflation expectations are anchored by a credible central bank, it does not.
• Where the economy is on SRAS.

CRITICAL LINK BACK TO §3.1
Nominal depreciation improves competitiveness only via the REAL rate:
   %ΔQ ≈ %Δe + π − π*
If the depreciation causes domestic inflation to rise by as much as
the nominal fall, the real exchange rate returns to where it started
and the competitiveness gain is fully eroded.
This is why depreciation is not a substitute for productivity growth.
It buys time. It does not buy competitiveness.

#5.9 Boundary case: contractionary depreciation

The whole of §5.7 assumed a depreciation is expansionary. For a large class of countries it is not. Three mechanisms:

(1) Balance-sheet effects — "original sin". Many developing and emerging economies borrow in foreign currency because lenders will not accept long-term local-currency debt. When the currency depreciates 30%, the domestic-currency value of that debt rises by 43% (1/0.7 − 1) overnight, while the domestic-currency revenue backing it is unchanged. Firms, banks and governments become insolvent. Investment collapses. AD falls despite the improvement in net exports. Formally, the fall in I outweighs the rise in (X − M).

(2) The real income effect. Where imports are necessities — food, fuel, medicine, fertiliser — a depreciation is a large negative real income shock to households, cutting consumption. In Egypt in March 2024, a 26.5% fall in the pound landed on an economy already running roughly 30% inflation.

(3) The distributional and political effect. The gains from depreciation accrue to exporters and import-competing producers; the losses fall immediately on all consumers of imports. The losses are visible and instant; the gains are diffuse and slow. This is why devaluations are politically difficult and often reversed before they can work.

WHEN DEPRECIATION FAILS — A CHECKLIST
□ ηₓ + ηₘ (weighted by X/M) below the threshold      → CA worsens
□ Large foreign-currency debt                        → balance-sheet contraction
□ Imports are necessities with no substitutes        → ηₘ near zero, permanently
□ Economy at full capacity                           → supply cannot respond
□ High import content of exports                     → gain largely cancelled
□ Wage indexation / unanchored expectations          → real gain eroded within a year
□ Trading partners depreciate too                    → no change in the REER at all
Tick two or more and the depreciation is unlikely to correct the deficit.

#5.10 Effects on foreign direct investment

Two opposing forces, and the good answer names both rather than picking one.

Depreciation attracts FDI because domestic assets — firms, land, labour — become cheaper in foreign currency. A US investor buying a British company at $1.30 per £1 rather than $1.50 saves 13% on the same asset. Production costs measured in the investor's home currency fall, raising expected returns. This raises inward FDI, which is a financial account credit.

Depreciation deters FDI because it signals instability. FDI is a long-horizon, illiquid commitment. What matters to the investor is the exchange rate at which future profits will be repatriated, not the rate at which the asset is bought. A currency that has just fallen 30% may fall another 30%, and the volatility raises the risk premium required. Persistent depreciation also implies persistent inflation, which raises operating costs.

The resolution: a one-off depreciation from an overvalued level attracts FDI; a chronic depreciation caused by macroeconomic instability deters it. The distinction is between a change in level and a change in trend, and it is precisely the sort of distinction that mark schemes call "an informed judgement".

There is also a current account feedback worth noting, and Pearson's own indicative content flags it: inward FDI generates future outflows of profits, interest and dividends, which are debits on the primary income account. Today's financial account credit is tomorrow's current account debit. This is exactly why the UK's primary income balance is negative (−0.7% of GDP in 2024) despite very large gross overseas assets.

#5.11 The effects of an appreciation

Everything above runs in reverse, and the exam does ask this way round (June 2023 Q8 asked for the effects of an appreciation on a developed country). Do not simply write the mirror image mechanically — some effects are genuinely asymmetric.

The asymmetry worth naming: an appreciation makes imported capital goods cheaper, which raises investment and long-run productive capacity, potentially offsetting the competitiveness loss over time. A depreciation does the opposite — it makes the machinery you need to become more competitive more expensive. This is a genuinely non-obvious point and is a strong evaluation line on both questions.

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#6. International competitiveness

#6.1 What competitiveness is, precisely

International competitiveness is the ability of a country's firms to sell goods and services in world markets relative to their rivals, sustainably and while raising living standards. The last clause matters. A country can always sell more by cutting wages toward zero; that is not competitiveness, it is impoverishment.

The specification names three measures: relative productivity, relative unit labour costs, and relative export prices. Note that all three are relative. Absolute improvement is worthless if rivals improve faster — a point the Pearson mark scheme makes explicitly: "Any measures taken have to be considered in the context of a dynamic global economy where other countries are also trying to increase their competitiveness" (WEC14, June 2021 Q8 indicative content).

#6.2 Productivity — defined and derived

Labour productivity = output per unit of labour input

  Output per worker = Y / L
  Output per hour   = Y / (L × H)     H = average hours per worker

Output per HOUR is the better measure: it is not distorted by
part-time working or by differences in hours worked per year.

Why productivity is the foundation of everything else: from the derivation in §6.3, unit labour costs are wages divided by productivity. From §4.4 (Balassa-Samuelson), tradable-sector productivity sets the wage level. From long-run growth theory, productivity determines real income per head. Everything in this section is a consequence of productivity except the exchange rate, and the exchange rate only buys time.

Real datum. UK output per hour worked rose 1.1% year on year in Q3 2025, and was 3.1% above its 2019 average (ONS, Productivity flash estimate and overview, UK, released 13 November 2025). Note the second figure: cumulative productivity growth of 3.1% over roughly six years is extremely weak by historical standards, and it is the central fact of UK competitiveness.

#6.3 Unit labour costs — derived and calculated

DERIVATION OF UNIT LABOUR COST

ULC = total labour cost ÷ real output
    = (W × L) ÷ Y            where W = compensation per worker
    = W ÷ (Y / L)
    = wage per worker ÷ output per worker
    = WAGE ÷ PRODUCTIVITY

In growth rates:
    %ΔULC ≈ %ΔW − %ΔProductivity

That two-line result is the most useful single equation in the competitiveness section. It says immediately that a country can pay high wages and still be competitive, provided productivity is high enough. Germany, Switzerland and the Netherlands pay very high wages and compete successfully; the wage level is not the issue, the wage-to-productivity ratio is.

WORKED EXAMPLE 1 — LEVELS

Economy X, year 1:
  Employment           1,000 workers
  Compensation         £40,000 per worker per year
  Real output          £60 million

  Total labour cost = 1,000 × £40,000       = £40,000,000
  Labour productivity = £60m ÷ 1,000        = £60,000 per worker
  ULC = £40m ÷ £60m                         = £0.667 per £1 of output
        (equivalently £40,000 ÷ £60,000)

Economy X, year 2:
  Wages rise 6% → £42,400
  Productivity rises 1.1% → £60,660 per worker
  Output = 1,000 × £60,660                  = £60,660,000
  Labour cost = 1,000 × £42,400             = £42,400,000
  ULC = £42.4m ÷ £60.66m                    = £0.699 per £1 of output

  %ΔULC = (0.699 ÷ 0.667) − 1               = +4.85%
  Cross-check with the growth formula:
  1.06 ÷ 1.011 − 1                          = +4.85%   ✓

The cross-check matters: the growth formula %ΔULC ≈ %ΔW − %ΔP is an approximation (6 − 1.1 = 4.9%), and the exact figure is 4.85%. Use the exact form in written work; the approximation is fine for mental checking.

#6.4 Relative unit labour costs in a common currency

Domestic ULC is not competitiveness. Competitiveness is domestic ULC relative to rivals', converted into a common currency. This is where the exchange rate enters, and it is the formal bridge between the two halves of this chapter.

DERIVATION: RELATIVE UNIT LABOUR COSTS

RULC = (ULC_domestic × e) ÷ ULC_foreign

  e = foreign currency per unit of domestic currency
  Numerator = domestic unit labour cost expressed in FOREIGN currency
  Denominator = foreign unit labour cost in its own currency

RULC rising = losing cost competitiveness.

In growth rates:
  %ΔRULC ≈ %ΔULC_dom − %ΔULC_for + %Δe

WORKED EXAMPLE 2 — RELATIVE ULC

UK unit labour costs rise            +4.85%   (from Worked Example 1)
Euro-area unit labour costs rise     +2.50%
Sterling appreciates against the euro +3.00%

%ΔRULC = 4.85 − 2.50 + 3.00 = +8.35%

UK cost competitiveness against the euro area deteriorates 8.35% in one year.
Only 2.35 points of that came from the labour market.
6.00 points came from the exchange rate and from rivals' restraint.

To hold RULC constant, sterling would have needed to DEPRECIATE by
2.35% — which is exactly what a floating rate would tend to deliver
under relative PPP.

Two conclusions follow, and both are examinable.

First, the exchange rate is a competitiveness instrument that acts instantly, whereas productivity acts over decades. That is why devaluation is tempting.

Second, the exchange rate cannot deliver a sustained competitiveness gain, because (§5.8) the depreciation raises import prices, which raises consumer prices, which raises wage claims, which raises ULC, which cancels the gain. The nominal rate falls; the real rate returns. Only productivity moves the real exchange rate permanently.

#6.5 Export prices and the terms of trade

TERMS OF TRADE = (index of export prices ÷ index of import prices) × 100

An improvement (a rise) means each unit of exports buys more units of imports. A deterioration (a fall) means the opposite.

WORKED EXAMPLE 3 — TERMS OF TRADE

Base year: export price index 100, import price index 100. ToT = 100.
Current:   export price index 118, import price index 104.
ToT = (118 ÷ 104) × 100 = 113.5      → an improvement of 13.5%

Growth form: if export prices rise 8% and import prices rise 3%,
%ΔToT = (1.08 ÷ 1.03) − 1 = +4.85%

The trap, and it is a deliberate one in this specification. An improvement in the terms of trade is not an improvement in competitiveness. It is very often the opposite. If export prices rise because the currency appreciated, or because domestic inflation was high, the terms of trade improve while competitiveness deteriorates. Each unit sold earns more, but fewer units are sold.

Whether an improvement in the terms of trade raises export revenue depends — again — on elasticity:

Export revenue = Pₓ × Qₓ
Export prices rise:  revenue rises if ηₓ < 1, falls if ηₓ > 1.
So a terms-of-trade improvement helps the current account only
when demand for exports is price-INELASTIC.

For commodity exporters whose world price is set externally, a terms-of-trade improvement is a genuine windfall — the price rise is exogenous and the quantity is largely unaffected. For manufactured-goods exporters facing close substitutes, the same "improvement" is a loss of market share. Always ask what caused the terms of trade to move before saying whether it is good.

#6.6 Price versus non-price competitiveness

Price competitiveness is everything above: costs, productivity, exchange rates, prices. Non-price competitiveness is everything else that makes a buyer choose your product at the same price or a higher one.

The structural argument for prioritising non-price competitiveness: price competitiveness is contestable and non-price competitiveness is not. Any rival can devalue tomorrow; no rival can replicate a fifty-year reputation for reliability by Friday. A country competing only on price is competing in the one dimension where it can always be undercut by a poorer country. Non-price competitiveness lowers the PED for exports, which — read back into §5.3 — reduces ηₓ, which means the country does not need a depreciation.

#6.7 Measures to improve competitiveness, with the mechanism for each

The specification requires you to know measures. The mark scheme requires you to know why each works. Here are both.

THE ORGANISING RULE
Everything except the exchange rate works through PRODUCTIVITY.
The exchange rate works through PRICE and is competed away.
That is the whole of competitiveness policy in two lines.

Evaluation lines, ready to deploy:

• Opportunity cost. Every pound spent on training is not spent on healthcare, or is financed by borrowing or taxation, both of which have their own costs.
• Time lags. Education policy today affects the workforce in fifteen years. A government facing an election in two has an incentive to reach for the exchange rate instead.
• Government failure. Governments choose the wrong skills, back the wrong sectors, and are lobbied by incumbents.
• Relative, not absolute. Rivals are doing the same things.
• Policy conflict. Lower interest rates to depreciate the currency also raise AD and inflation, which erodes the real gain (§5.8).
• Constrained instruments. A member of a monetary union has no exchange rate; a member of a customs union may not use subsidies or tariffs.

#6.8 Boundary case: Dutch disease

Named for the Netherlands after the Groningen gas discovery, this is the mechanism by which a good thing — a resource windfall — destroys competitiveness in everything else.

DERIVATION: DUTCH DISEASE

Discovery or price boom in a natural resource.

CHANNEL 1 — the spending effect
  Resource rents raise national income
  → higher demand for NON-TRADABLES (housing, services, construction)
  → their prices P_N rise (they cannot be imported)
  → the real exchange rate P_N/P_T rises = REAL APPRECIATION
  → and this happens even under a FIXED nominal exchange rate.

CHANNEL 2 — the resource movement effect
  The booming sector bids labour and capital away from manufacturing
  → economy-wide wages rise
  → from §6.3, ULC rises in the non-resource tradable sector
  → manufacturing loses competitiveness and contracts.

CHANNEL 3 — the nominal channel
  Resource exports generate large foreign currency inflows
  → demand for the domestic currency rises
  → nominal appreciation, compounding channels 1 and 2.

RESULT: de-industrialisation. When the resource is depleted or its
price falls, the manufacturing base that would have replaced it is gone.

The consequences are worse than temporary contraction, because manufacturing carries the learning-by-doing and technology spillovers that drive long-run productivity growth. Losing it is not a reversible reallocation.

Nigeria as the case. Petroleum products were 88.26% of Nigeria's total export value in 2024, with agriculture contributing 5.73% out of a total of ₦77.44 trillion (National Bureau of Statistics, 2024). A country with that export structure has three linked problems: the exchange rate is hostage to the oil price; non-oil tradables cannot compete because the real exchange rate is set by oil; and government revenue is as volatile as the oil price. The naira depreciated 51.46% in 2023 and 129.23% in 2024, averaging ₦1,478.97 per US dollar in 2024 (World Bank data, via Intelpoint), following the move to a market-determined rate — a delayed, disorderly correction of an accumulated real overvaluation, exactly as in Egypt.

Policy responses, which are examinable as evaluation:

• Sovereign wealth funds — save the rents offshore so they do not raise domestic demand for non-tradables. Norway's is the standing example; the mechanism is to break Channel 1 by holding the money outside the economy.
• Diversification policy — subsidise or protect non-resource tradables to preserve the learning externality.
• Fiscal rules — spend only the permanent income from the resource, not the annual receipts.

#6.9 Boundary case: why competitive devaluation is self-defeating in aggregate

A single country can gain competitiveness by depreciating. All countries cannot. Here is why, derived.

DERIVATION: THE ADDING-UP CONSTRAINT

An exchange rate is a RELATIVE price. If A depreciates against B,
B has by definition appreciated against A. Summing over all pairs,
weighted by trade shares:

     Σᵢ wᵢ × %ΔREERᵢ = 0

The trade-weighted real exchange rates of all countries cannot
fall simultaneously. There is no external planet to depreciate against.

Equivalently, on the trade side: one country's exports are another's
imports, so world current account balances sum (in principle) to zero:

     Σᵢ CAᵢ = 0

Therefore a policy of raising net exports cannot succeed for
everyone at once. Any aggregate gain is arithmetically impossible.

What is left when the competitiveness gain cancels out is the set of side-effects, all of which are negative:

• Imported inflation everywhere. Each country's import prices rise, and no country's export prices fall in relative terms. The world gets the cost-push without the volume gain.
• Retaliation and escalation. Each round of depreciation invites the next. The 1930s "beggar-thy-neighbour" devaluations are the historical case, and they were accompanied by tariff escalation and a collapse in world trade.
• Loss of monetary credibility. A central bank that has demonstrated it will devalue for competitive reasons has told markets that its inflation target is negotiable, which raises inflation expectations and therefore the interest rate required in future.
• Trade policy retaliation. Currency depreciation is functionally equivalent to a uniform export subsidy plus a uniform import tariff, and trading partners increasingly treat it as such.

This is why the IMF's Articles of Agreement prohibit members from manipulating exchange rates to gain an unfair competitive advantage, and why the G20 repeatedly commits to refrain from competitive devaluation. The commitment device exists because the individual incentive is real and the collective outcome is negative — a prisoner's dilemma in exchange rate policy.

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#7. Correcting imbalances

Suppose a country has decided its current account deficit is a problem. There are three families of policy, and they differ in mechanism, in time profile, and in what they cost.

#7.1 Expenditure-switching policies

Definition. Policies that change the relative price of domestic and foreign goods, switching demand from foreign to domestic output without necessarily reducing total spending.

Instruments: devaluation or depreciation (engineered by intervention, lower interest rates, or QE); tariffs; quotas; export subsidies; and — the only durable one — measures that raise non-price competitiveness.

Mechanism. Exactly as derived in §5: relative prices change, and if the weighted elasticity condition holds, X rises and M falls.

Why it can fail. Every item in the §5.9 checklist. Plus the deepest objection, which comes from §2.6: from the absorption identity CA = Y − A, a policy that switches expenditure but does not change either output or absorption cannot change the current account. If the economy is at full capacity so Y cannot rise, expenditure-switching just bids up domestic prices until the real exchange rate returns to where it was. Expenditure-switching requires spare capacity to work. This is the single most sophisticated evaluation point available on this question and it comes straight from an identity.

Time profile: negative for one to four quarters (the J-curve dip), then positive, then decaying as inflation erodes the real gain.

#7.2 Expenditure-reducing policies

Definition. Policies that reduce total domestic demand, cutting imports because imports are a function of income.

Instruments: contractionary fiscal policy (higher taxes, lower government spending); contractionary monetary policy (higher interest rates, quantitative tightening).

Mechanism, as a chain:

Higher taxes / lower G / higher interest rates
→ disposable income and/or the incentive to spend falls
→ C and I fall; AD falls
→ national income falls by (multiplier × initial fall)
→ imports fall by (marginal propensity to import × fall in income)
→ the current account deficit narrows

Worked calculation. Suppose an economy has a marginal propensity to import of 0.25 and a multiplier of 1.5. The government cuts spending by £10bn.

• Fall in national income = 1.5 × £10bn = £15bn.
• Fall in imports = 0.25 × £15bn = £3.75bn.
• The current account improves by £3.75bn — at a cost of £15bn of lost output.

That ratio is the whole story of expenditure-reducing policy: it works reliably, and it is expensive. Note the arithmetic is unambiguous — no elasticity condition is required. This is why the IMF's stabilisation programmes always contain expenditure-reducing components: they are the only instrument that is guaranteed to move the current account.

Why it works when switching fails. Return to CA = Y − A. Expenditure-reducing policy directly cuts A. It does not depend on relative prices, elasticities, contract lags or pass-through. It is the identity-guaranteed instrument.

Costs: lower growth, higher cyclical unemployment, lower tax revenue partially offsetting the fiscal tightening, and — if it cuts public investment — lower long-run productive capacity.

Time profile: effective within two to six quarters; the fastest reliable instrument.

#7.3 Supply-side policies

Definition. Policies that raise productive capacity and productivity, improving competitiveness at any given exchange rate.

Instruments: the entire §6.7 table except the exchange rate row.

Mechanism. Higher productivity lowers ULC (§6.3), which lowers relative export prices (§6.4), which raises export volumes and displaces imports. Simultaneously, higher potential output raises Y in the identity CA = Y − A, improving the current account without any reduction in domestic living standards.

This is the only family of policies that improves the current account without a cost to output. That is why every serious answer on correcting imbalances concludes with supply-side policy, and why the honest evaluation is about time, not about effectiveness.

Costs: opportunity cost of public spending, government failure, and — decisively — a lag measured in years to decades.

#7.4 The time profile, compared

THE POLICY-MIX RULE
Expenditure-switching alone: changes relative prices but not absorption.
                            Fails at full capacity.
Expenditure-reducing alone: cures the deficit by causing a recession.
                            Politically and economically expensive.
The two together: switching provides the demand for domestic output
                  that reducing has released. This is why IMF programmes
                  bundle devaluation WITH fiscal tightening.
Supply-side: the only durable cure, and far too slow to be the whole answer.

That final box is a complete, defensible informed judgement for a 20-mark question. It recognises different viewpoints, is critical of each, and reaches a supported conclusion — precisely the Level 3 evaluation descriptor.

#7.5 Do nothing: the case for tolerating an imbalance

The strongest evaluation available on this question is often that no correction is needed, and Pearson's mark schemes reward it explicitly.

• Under a float, the imbalance is self-correcting through the exchange rate, provided elasticities are adequate.
• A deficit financed by long-term FDI inflows is more sustainable than one financed by short-term portfolio flows, because FDI cannot be withdrawn overnight.
• A deficit caused by imports of capital equipment raises future productive capacity and therefore future export capacity. Pearson's own indicative content: "May be desirable if trade imbalances are caused by the imports of capital goods which would increase the country's productive capacity."
• Size relative to GDP matters, not the absolute number. The October 2025 mark scheme states it directly: "It is not the overall size of the current deficit that is significant, but how much it is as a percentage of GDP." The UK's 2.2% of GDP in 2024 is a very different proposition from the same absolute number in a smaller economy.
• The correction may cost more than the problem. Expenditure-reducing policy trades £15bn of output for £3.75bn of current account improvement.

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#8. Global imbalances and their significance

#8.1 The pattern

Note the arithmetic requirement: world current account balances must sum to approximately zero. The US deficit and the Chinese and German surpluses are not independent facts. They are the same fact viewed from two sides.

#8.2 Why the imbalances persist — the derivation from CA = S − I

From §2.6, CA = S − I. Therefore a persistent surplus is a persistent excess of saving over investment, and a persistent deficit the reverse. So the question "why do global imbalances persist?" becomes "why do saving and investment rates differ persistently across countries?" — a far more tractable question.

Why China saves so much:

• A thin social safety net raises precautionary household saving for healthcare, education and retirement.
• A high corporate saving rate: state-owned enterprises retain earnings rather than paying dividends.
• Demographics: a large cohort in peak saving years, and the legacy of the one-child policy raising saving for old age.
• Financial repression: households historically earned low real returns on deposits, requiring higher saving to hit a target wealth level.
• An exchange rate and industrial policy oriented toward tradable production.

Why Germany saves so much:

• An ageing population saving for retirement.
• Corporate saving in a bank-financed Mittelstand model.
• Fiscal rules constraining public dissaving.
• Membership of a monetary union: Germany cannot appreciate against its main trading partners, so the standard adjustment mechanism is switched off. This is the crucial structural point — a surplus inside a currency union is far harder to unwind than one outside it.

Why the US saves so little:

• Persistent large fiscal deficits are negative public saving.
• A deep, liquid consumer credit system supports high consumption.
• The exorbitant privilege. The dollar is the world's principal reserve currency. Foreign central banks and private investors demand dollar assets for reasons unrelated to their return: for reserves, for trade settlement, for safety in crises. That demand appreciates the dollar and finances the deficit at a lower interest rate than any other borrower could obtain. The US can therefore run deficits that would have triggered a currency crisis anywhere else.

The last point contains the "savings glut" hypothesis: if the rest of the world wants to hold more dollar assets than the US wants to sell, the adjustment happens through a stronger dollar and a wider US deficit. On that reading the US deficit is partly caused by foreign surpluses, not by American profligacy alone. Whichever direction you emphasise, saying that the causation is contested is exactly the sort of "critical of the evidence" judgement the Level 3 evaluation descriptor demands.

#8.3 Why they matter

Risk 1: disorderly unwinding. If foreign investors' appetite for deficit-country assets falls abruptly, the currency falls sharply, interest rates spike to attract replacement financing, and a recession follows. The larger the accumulated NIIP, the larger the potential adjustment.

Risk 2: protectionism. Persistent bilateral deficits are politically potent, and the political response is tariffs and trade restrictions, which reduce world output by distorting comparative advantage — while doing very little to the multilateral balance, because that balance is determined by saving and investment, not by trade policy. This is a direct application of CA = S − I: a tariff that does not change saving or investment cannot change the current account; it merely redirects the deficit to a different partner.

Risk 3: asset price and credit distortion. Capital flowing into deficit countries compresses their long-term interest rates, encouraging leverage and asset price inflation. The pre-2008 build-up is the standard illustration.

Risk 4: deflationary bias. Surplus countries are not obliged to adjust — they face no reserve constraint — while deficit countries eventually are. Adjustment therefore falls asymmetrically on deficit countries, which must contract. Globally this produces a bias toward deficient demand. This asymmetry has been recognised since Keynes proposed a penalty on persistent surpluses at Bretton Woods, and it was not adopted.

Counter-arguments, for evaluation:

• Imbalances are a natural consequence of integrated capital markets and different demographic profiles. A young, fast-growing economy should import capital and run a deficit; an old, rich one should export capital.
• The IMF's own assessments treat only the excess portion of a balance — the part not explained by fundamentals — as a problem.
• The deficit country receives real goods and services today in exchange for paper claims; the surplus country does the opposite. It is not obvious who has the better deal.
• Imbalances have persisted for decades without the predicted crisis, which is at least prima facie evidence that they are more sustainable than the alarm suggests.

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#9. Assumptions, limitations and boundary cases — consolidated

Every model in this chapter is conditional. This table is the evaluation bank: each row is a ready-made critical point with its mechanism attached.

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#10. Exam application: WEC14

#10.1 The paper and where the marks are

#10.2 The assessment objectives, and why AO4 dominates

Pearson's published weightings for Unit 4 as a share of the whole IAL are AO1 4.7%, AO2 5.6%, AO3 7.2%, AO4 7.5%, summing to the unit's 25% of the qualification. Rescaled to the unit itself:

AO1 (knowledge)   4.7 / 25 = 18.8%
AO2 (application) 5.6 / 25 = 22.4%
AO3 (analysis)    7.2 / 25 = 28.8%
AO4 (evaluation)  7.5 / 25 = 30.0%   ← the largest

Cross-check it directly from the mark allocations. Evaluation marks on the paper: 2 (the 8-mark Section B part) + 6 (7e) + 8 + 8 (the two Section C essays) = 24 marks out of 80 = 30%. The two methods agree exactly.

Implication. Evaluation is the single largest assessment objective in this paper. Yet the examiner reports say, in every series from October 2021 to January 2025: "Evaluative comments were often made and, whilst some offered supporting evidence and were linked to the context, many were unable to offer logical chain of reasoning." The largest AO is also the worst-answered. That is where the marks are.

#10.3 The country gate

Section C carries a hard cap:

"N.B. Award maximum of Level 3 (9 marks) if a candidate does not refer to a developed/developing country/a country of their choice in their answer."

Across sixteen live series (October 2020 to October 2025), 44 of the 48 Section C questions carry an explicit gate — 91.7%. The exceptions are all three October 2023 questions and January 2024 Q9, and in every one of those cases the examiner report re-imposed the requirement in prose. Treat the gate as unconditional. Every examiner report from October 2021 onward states: "A reference to a country will always form part of the questions in Section C."

The categories are not interchangeable. The evidence on placement is precise, and slightly different from the common claim:

So the practical rule is: the developed-country gate lives on Q8 or Q9; the developing-country gate lives overwhelmingly on Q10. Writing about Germany on a question gated to a developing country caps you at 9 out of 12 for KAA regardless of quality. Read the final sentence of the question before you plan.

COUNTRY GATE — OPERATING RULES
Read the last sentence of the question first. Underline the category.
"Developed" means an advanced economy. Japan, Germany, UK, USA, Canada.
"Developing" means a low- or middle-income economy. India, Nigeria, Egypt, Pakistan.
Emerging economies (China, Brazil) are safest on "a country of your choice".
The gate caps KAA at 9. It does NOT cap evaluation.
Naming a country is not application. You must use its data.

That last line is the most repeated sentence in the entire corpus of examiner reports: "A reminder that just writing a country name in the answer does not merit as application."

#10.4 Chain structure

The mark scheme distinguishes levels almost entirely by chain length and integration.

The most repeated criticism across the whole corpus: "Most of the answers only carried a two-stage chain of reasoning, and therefore, they were not able to access Level 3 KAA."

CHAIN TEMPLATE — FOUR STAGES MINIMUM, ENDING IN A FIGURE

Stage 1  Trigger, with the country and a dated figure.
Stage 2  The immediate economic mechanism.
Stage 3  The transmission to a macro variable.
Stage 4  The named macro outcome, with a direction AND a number.

Never end at "the economy improves". End at
"the current account deficit narrows from 2.2% of GDP toward balance".

A Level 4 chain, written out. Question: evaluate the likely economic effects of a depreciation of a country's currency; refer to a developed country of your choice.

The UK ran a current account deficit of 2.2% of GDP in 2024, driven by a goods deficit of 7.3% of GDP that a services surplus of 6.4% only partly offset (ONS, Pink Book 2025). [Stage 1] A 10% depreciation of sterling lowers the foreign-currency price of UK exports by 10% while raising the sterling price of imports by 11.1%, since the reciprocal of 0.9 is 1.111. [Stage 2] Whether the current account improves depends on the Marshall-Lerner condition: export revenue in sterling rises for any positive export elasticity, but import expenditure falls only if the import elasticity exceeds one, so the sum ηₓ + ηₘ must exceed one. [Stage 3] Because roughly half the UK's goods imports are relatively price-inelastic — fuel, food and intermediate components embedded in UK exports — the short-run elasticity sum is likely below one, so the deficit would first widen along the J-curve before the deficit narrows from 2.2% of GDP toward balance over two to three years. [Stage 4]

Four stages. Two dated figures. Country integrated at every stage, not bolted on. Two named models used, not merely named.

#10.5 Evaluation that reaches Level 3

The Level 3 descriptor requires evaluation that "recognises different viewpoints and/or is critical of the evidence, leading to an informed judgement", supported by a logical chain and referenced to context.

EVALUATION TEMPLATE — FOUR MOVES
1. State the condition under which the analysis fails.
2. Explain WHY, with a mechanism (not an assertion).
3. Anchor it to the country and to a figure.
4. Judge: which case is more likely HERE, and why.

Worked example, on the same question:

However, the size of the depreciation matters as much as its direction. Sterling fell 8.33% against the dollar in a single day on 24 June 2016, its worst daily fall since records began in 1971 (City A.M.), yet the UK current account deficit had only narrowed from 3.6% of GDP in 2023 to 2.2% in 2024, and that improvement came mainly from primary income rather than trade (ONS). [1 and 3] The mechanism is that a large share of UK exports embody imported components, so a depreciation raises exporters' input costs at the same time as it lowers their foreign-currency prices, cancelling much of the competitiveness gain; and UK exporters facing branded, differentiated demand tend to take the gain in margin rather than in volume, so pass-through is well below 100%. [2] On balance, therefore, depreciation is more likely to raise exporters' profits than to correct the UK's structural goods deficit, which reflects a productivity problem — output per hour grew just 1.1% in the year to Q3 2025 (ONS) — that no exchange rate can solve. [4]

#10.6 The traps that score zero

The examiner reports document each of these repeatedly.

• Answering the wrong question. "Some focussed on depreciation, and this meant that they were not able to access any marks as their analysis was not accurate" (June 2023 Q8, which asked about appreciation). Read the direction word.
• Evaluating causes with solutions. "Majority offered effects of a depreciation and this got no credit" (October 2024 Q10, which asked for causes). If the question asks for causes, evaluate the causes — not their consequences or their remedies.
• Listing. "Those who listed evaluation points achieved Level 1." Two developed points beat six listed ones.
• Naming without using. A country name with no data attached is not application.
• Breadth over depth. "Candidates are not expected to write four analysis and three evaluation points… They can select two analysis points and develop them."
• Copying the extract in Section B. "Many copied paragraphs from the extract and did not explain it."
• Dropping the unit in 7(a). The unit is worth 1 of the 2 marks: "22.22%" scores 2, "22.22" scores 1.
• Evaluating a 4- or 6-mark question. "Some candidates evaluated their analysis points, but this was not credited as this is not a requirement of the question."

#10.7 The positive/negative flip

Mark schemes on this topic repeatedly print: "N.B. Award positive effects as KAA and negative as evaluation (or vice versa)." This is a licensed structure, and it is efficient:

STRUCTURE FOR "EVALUATE THE EFFECTS OF X"
Para 1  Positive effect 1, four-stage chain, country data.
Para 2  Positive effect 2, four-stage chain, country data.
Para 3  Negative effect 1 as evaluation, with mechanism and context.
Para 4  Negative effect 2 as evaluation, with mechanism and context.
Para 5  Informed judgement: which dominates, under what conditions, here.
Two KAA points. Two EV points. One judgement. Nothing else.

#10.8 Topic probability

Across 48 live Section C questions from October 2020 to October 2025, exchange rates appeared five times and the current account five times — together, more than one in five of all essay questions. The exact wordings used:

• "Evaluate the economic effects of a depreciation of a country's currency." (June 2021 Q10)
• "Evaluate the likely economic effects of an appreciation of a country's currency on its economy. Refer to a developed country of your choice." (June 2023 Q8)
• "Evaluate policies that can be used to prevent a country's exchange rate from depreciating. Refer to a developed country of your choice." (June 2024 Q8)
• "Evaluate factors that might cause a depreciation of the exchange rate of one currency against another currency. Refer to a developing country of your choice." (October 2024 Q10)
• "Evaluate the possible causes of a current account deficit. Refer to a developed country of your choice." (October 2025 Q8)
• "Evaluate the disadvantages of a current account deficit to a developing country of your choice." (October 2021 Q10)
• "Evaluate possible causes of a current account surplus. Refer to a developed country of your choice." (January 2023 Q9)
• "Evaluate factors that influence a country's international competitiveness. Refer to a developed country of your choice." (June 2022 Q9)

Note how often the question asks for causes or factors rather than effects. Those are different essays. Prepare both directions for every concept in this chapter.

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#11. Self-test drills

Each drill has a binary pass/fail criterion. Do not award yourself partial credit.

Drill 1 — Marshall-Lerner, numerical. A country has exports of £200bn and imports of £200bn. Its currency depreciates 20%. ηₓ = 0.6, ηₘ = 0.5. Calculate the new current account balance. Pass criterion: you produce a number, and you use 1/0.8 = 1.25 for the import price rise, not 1.20.

Model answer. Import price rises by 1/0.8 − 1 = +25%. Export volume: +0.6 × 20% = +12%, so export revenue = 200 × 1.12 = £224bn. Import volume: −0.5 × 25% = −12.5%, index 87.5. Import expenditure = 200 × 1.25 × 0.875 = £218.75bn. Current account = 224 − 218.75 = +£5.25bn, a surplus. Consistent with ηₓ + ηₘ = 1.1 > 1.

Drill 2 — Marshall-Lerner, the general form. A country has exports of £60bn and imports of £100bn. ηₓ = 1.2, ηₘ = 0.2. Does a depreciation improve the current account? Pass criterion: you apply (X/M)ηₓ + ηₘ > 1, not ηₓ + ηₘ > 1, and you get the opposite answer to the naive test.

Model answer. Naive test: 1.2 + 0.2 = 1.4 > 1, "improves". General test: (60/100) × 1.2 + 0.2 = 0.72 + 0.2 = 0.92 < 1, so it does not improve. Because exports are only 60% of imports, the export elasticity is discounted; the country needs a higher elasticity sum than a balanced-trade country. The general form is correct and the naive form is wrong here.

Drill 3 — the J-curve, mechanism. State, without using the words "time lag", why the current account worsens immediately after a depreciation. Pass criterion: your answer contains the phrase "volumes are fixed" or an equivalent, and identifies the effect as a pure valuation effect on imports.

Model answer. In the first months, trade volumes are fixed by contracts signed earlier, so ηₓ = ηₘ ≈ 0. Substituting into ΔCA = d[Xηₓ + Mηₘ − M] gives ΔCA = −dM. The same physical imports cost more domestic currency while export earnings in domestic currency are unchanged. It is a pure valuation effect with no volume offset.

Drill 4 — unit labour costs. Wages rise 7%; productivity rises 2%; the currency appreciates 4% against a competitor whose ULC rises 1%. Compute the change in relative unit labour costs. Pass criterion: you get +8.0% (or 7.94% exact) and you state that competitiveness has deteriorated.

Model answer. %ΔULC ≈ 7 − 2 = +5% (exact: 1.07/1.02 − 1 = +4.90%). %ΔRULC ≈ 4.90 − 1 + 4 = +7.90%. Cost competitiveness deteriorates by nearly 8% in one year, of which 4 points come from the exchange rate alone.

Drill 5 — the real exchange rate. A country depreciates 15% nominally. Its inflation is 18%; its partners' is 3%. What has happened to its real exchange rate? Pass criterion: you compute approximately zero and conclude no competitiveness gain.

Model answer. %ΔQ ≈ %Δe + π − π* = −15 + 18 − 3 = 0%. The real exchange rate is unchanged. The depreciation delivered no competitiveness gain whatsoever; it delivered only the inflation.

Drill 6 — the identity. A country runs a current account deficit of $40bn. Its capital account is zero and net errors and omissions are −$3bn. What is the financial account balance, and what does it mean economically? Pass criterion: you get a net inflow of $43bn and describe it as a net sale of domestic assets to foreigners.

Model answer. CA + KA + FA + E&O = 0, so −40 + 0 + FA − 3 = 0, giving FA = +$43bn of net inflows. Foreigners acquired $43bn more claims on this economy than its residents acquired abroad. The deficit was financed by selling assets or incurring liabilities, not by "losing money".

Drill 7 — the absorption identity. Explain in two sentences why a devaluation cannot improve the current account of an economy at full employment. Pass criterion: your answer uses CA = Y − A explicitly.

Model answer. CA = Y − A. At full employment Y is fixed, so unless the devaluation reduces absorption A, the current account cannot improve; instead domestic prices rise until the real exchange rate returns to its starting level.

Drill 8 — interest rates and the currency. A central bank raises its policy rate from 8% to 25% and the currency falls. Explain without contradicting uncovered interest parity. Pass criterion: you introduce a risk premium term explicitly.

Model answer. UIP with risk is i − i* = expected depreciation + ρ. The 17-point rate rise raised i, but by signalling distress it raised the risk premium ρ by more. The required expected depreciation therefore rose, and with the long-run expected rate anchored, the spot rate had to fall immediately.

Drill 9 — PPP and Balassa-Samuelson. A Big Mac costs $5.79 in the US and $2.62 in India. Is the rupee 55% undervalued? Pass criterion: you say no, and give the non-tradable/productivity reason.

Model answer. No. A Big Mac is largely non-tradable — rent, local labour, local utilities — and the law of one price applies only to tradables. Under Balassa-Samuelson, India's lower tradable-sector productivity means lower wages, which means cheaper non-tradables, which means a permanently lower price level in a common currency. Most of the gap is an equilibrium feature, not a misalignment. (Big Mac prices in USD: World Population Review compilation of The Economist's index, accessed June 2026.)

Drill 10 — the country gate. A question ends "Refer to a developing country of your choice in your answer." You write a superb 20-mark answer about Japan. What is your maximum mark? Pass criterion: you say 9 for KAA, and note evaluation is not capped.

Model answer. KAA is capped at Level 3, i.e. 9 out of 12, by the N.B. Evaluation is not gated, so up to 8 remains available — a maximum of 17. In practice an answer built entirely on the wrong country category will also struggle to contextualise its evaluation, so the realistic outcome is well below that.

Drill 11 — terms of trade. Export prices rise 12%; import prices rise 5%. Compute the change in the terms of trade and state whether competitiveness has improved. Pass criterion: +6.67%, and you say competitiveness has probably deteriorated.

Model answer. ToT change = 1.12/1.05 − 1 = +6.67%, an improvement in the terms of trade. But competitiveness has probably deteriorated: export prices rose faster than import prices, so domestic goods became relatively dearer. Export revenue rises only if ηₓ < 1.

Drill 12 — chain construction. Write a four-stage chain ending in a named macro outcome with a direction and a figure, starting from "a rise in domestic interest rates". Pass criterion: exactly four distinct causal stages, and the last one contains a number and a unit.

Model answer. A rise in UK Bank Rate raises the return on sterling-denominated assets relative to foreign assets. [1] Arbitrage requires an offsetting expected depreciation, so with the long-run rate anchored, spot sterling appreciates immediately. [2] A stronger pound raises the foreign-currency price of UK exports and lowers the sterling price of imports, so net exports fall provided ηₓ + ηₘ > 1. [3] AD falls, and with the UK goods deficit already at 7.2% of GDP in Q4 2025 (ONS), the current account deficit widens from 1.1% of GDP toward 2% while CPI inflation is pulled down by cheaper imports. [4]

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#12. Reference card

BoP:  CA + KA + FA + E&O = 0. A deficit = net asset sale, not lost money.
CA = S − I = Y − A. Switching fails at full capacity; reducing always works.
e = foreign per domestic. Depreciation = e falls.
Real rate Q = eP/P*. %ΔQ = %Δe + π − π*. Inflation eats depreciation.
PPP from law of one price: %Δe = π* − π. Breaks on non-tradables (Balassa-Samuelson).
UIP: i − i* = expected depreciation + ρ. Rate rise weakens if Δρ > Δi.
Marshall-Lerner: ΔCA = d[Xηₓ + Mηₘ − M] > 0 ⟺ (X/M)ηₓ + ηₘ > 1.
J-curve = Marshall-Lerner with elasticities rising over time.
ULC = wage ÷ productivity. RULC = ULC_dom × e ÷ ULC_for.
Trinity: fixed rate, free capital, own monetary policy — pick two.
Exam: 4-stage chains, dated figures, right country category, informed judgement.

(100 words.)

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#13. Sources for every figure used

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